South Korea takes nuclear threat in its stride

When a country is threatened with total destruction in a sea of fire, you’d think that international investors would be rushing to sell. And when the state voicing the threat is as unpredictable as North Korea, pulling out all investments would seem perfectly logical. However, since North Korea began beating its chest on October 16, investors have kept their nerve and South Korea has yet to suffer a rush of exiting investors.

“It’s like living on the Saint Andreas fault. There’s going to be a tremor every now and then and you know that one day it could fall into the sea. But you play down the risk and live with it,” says Bill Belchere, JPMorgan’s chief economist for Asia, sitting comfortably in Hong Kong.

The Korea Composite year to date has only slightly underperformed its regional and global peers. In January, it fell 12% compared with Taiwan, which slipped 9%, and the Philippines, down 10%. The Korean fall follows a 16% rally between October and December 2002, when North Korea became more bellicose and admitted to a secret nuclear programme.

With foreign investors now owning 35% of the Korean stock market, observers are impressed and puzzled by the way it has stood its ground. “Although this is rather more than the escalation we have seen in the past, South Korea’s markets are taking it in their stride,” says Deutsche Bank’s chief economist for Asia, Michael Spencer. “And it surprises me a little, given the fact that for the past year everyone has been pricing in Iraq into other markets. I would have thought that they would have started looking at Korea’s market and wondering what to price in. But I don’t see that.”

Locals express surprise that the situation is getting as much attention as it is. The economy is faring well and South Koreans are busy discussing ways of spending their bonuses and how to pay off their credit card bills. A Korean head of investment banking at a foreign house says of the situation: “It’s all just a North Korean tactic and we aren’t shocked at all. We know that we aren’t going to war tomorrow. People need to come on-shore and see that it’s business as usual.”

Despite such local confidence, it’s impossible to discount conflict totally. And it is certain that there would be no value left in the Korean market if there was war on the peninsula. Some selling out to reduce risk would seem to make sense. But technical factors and fundamental views are supporting the market.

Desmond Supple, managing director of Barclays Capital Asian credit research explains: “It might seem like a blasé approach, but what is moderating the response is indexing. And you are starting to get more funds into that. Also Korea is seen as an emerging market and not a bad one to get into, and since US investors tend to trade in packs, flows are more biased to come into Korea.”

David Craig, based in Seoul with Macquarie Asset Management, argues that now is the perfect opportunity to invest. He says: “The equity market looks remarkably cheap. So our view is that it’s not a bad time to be buying into the market.” He will continue to maintain faith in a small number of the country’s large companies such as Samsung Electronics and certain utilities.

Fixed-income investors also remain sanguine. Spreads have so far widened only 25 basis points. And this has more to do with an increase in the supply of paper than North Korean bellicosity.

A slight tremor

However, in mid-January the primary market did experience a slight tremor. Kookmin Bank decided to postpone its $835 million hybrid offering. There was speculation that it was the first victim of the North Korean crisis in the Asia-dollar bond market and that the bank was worried its spreads would blow out because of the geopolitical risk. But sovereign dollar-bonds had widened by only 3bp in the previous three days.

One banker close to the deal says the delay was not because of the North but does not elaborate. That would suggest there are fundamental internal issues with Kookmin, or problems with the structure of the deal.

This view seemed to be confirmed when Korea Development Bank came to the market almost straightaway with a $500 million tap on January 23. “The sovereign and KDB just aren’t affected by the situation,” says Dillip Shahani, a credit analyst at HSBC. “When KDB issued and spreads widened, it was because of supply. It means they can come when they want to. And corporates that need funding can do the same.”

That’s good news for debt capital markets bankers who are, perhaps influenced by self-interest, bullish about Korea’s prospects for the year. As much as 40% of the region’s issuance – more than $8 billion – is due from the country in 2003. Banks could be a big source of new supply as financial institutions look to increase their tier-one capital. Bankers say that Kookmin Bank will return to the market looking for $500 million to $850 million, that Woorie Bank will attempt to issue $500 million, and Korea Exchange, ChoHung, Koram and Korea First Bank will each offer $200 million.

In addition, the sovereign is looking to issue $3 billion or more. Export-Import Bank of Korea and Industrial Bank of Korea could do $3 billion between them and the four power companies could do deals amounting to around $1.2 billion.

Only the rating agencies appear cautious. Korea has been expecting an upgrade. But by the end of January Moody’s confirmed the country’s fears and announced that it had no intention of upgrading it in this tense climate. However, it did maintain its positive outlook. Tim Condon, ING’s chief economist for Asia, believes that “if it was just the economy, then they would have been upgraded. But the potential for catastrophe is holding it back. When the headlines are down the upgrade will follow.” For now the bond market is still priced for an upgrade. “At the moment, good news is still priced in, but bad news isn’t,” says a banker.

Shahani from HSBC and Barclays Capital’s Supple both believe that the rating is also being capped by the likelihood that in the shorter term the implosion of North Korea is more probable than its starting a war.

Such a collapse wouldn’t come cheap. Shahani says: “If North Korea does collapse then part of the expense of that is going to fall on the South. It’s a political and contingent liability cost. So even if the South looks very favourable, the contingent liability is if North Korea collapses.”

Some investors won’t feel truly comfortable until the day arrives. That’s because then their investments in South Korea will no longer be vulnerable to the rantings of the desperate leaders in the North.